Tax Savings Available to High Earners from S-Corporations

An S-corporation is a tax election that an owner can make under Subchapter S of the IRS Code. If an S-corp election is made, corporate income, losses, deductions, and credits pass through to the corporation’s shareholders for federal tax purposes, similar to how sole-proprietorships or single-member LLCs get taxed. For higher income earners, an S-corp can potentially provide large tax savings. The S-corp does this by splitting your earnings into 2 components: a wage and a shareholder distribution. 

Let’s look at an example for someone with $100k of income. As an employee of your own S-corp you have to pay yourself a reasonable wage, which many people try to keep low to minimize payroll taxes (note that setting this too low can get you audited by the IRS, so consult with a tax professional). In the below example, we assume our $100k S-corp owner designates their “reasonable salary” as $50k, which includes all of their fringe benefits like healthcare. While they have to pay federal unemployment taxes of $420 now, the savings are still material by shifting some of your earnings from income/wages to shareholder distributions (note that certain states may have additional unemployment taxes for S-corps, and other additional taxes compared to our simplified version below; it varies state to state so we have not included these differences here).

ItemS-Corp w/ 50% WagesNo S-Corp
Thereof: Wages$50,000$0
Social Security + Medicare($7,560)($15,300)
Federal Unemployment Taxes*($420)$0
Total Payroll Taxes($8,070)($15,300)

*Some states also have an unemployment insurance tax.

The payroll tax savings are not the only benefit, though. The S-corp shareholder distributions are typically taxed as long term capital gains, which is a lower rate than the federal income tax rate. For our $100k earner, the long term capital gain rate is only 15% versus a federal income tax rate of 24%.

ItemS-Corp w/ 50% WagesNo S-Corp
Wages/Income Subject to Personal Income Tax Rate$50,000$100,000
Less: Employer Portion of Payroll Taxes($8,070)($7,650)
Taxable Income$41,930$92,350
Federal Income Tax Rate (24%)($10,063)($22,164)
Shareholder (“S/H”) Stock Basis (a)$0
50% of Earnings not in Wages (b)$50,000
Distribution in Excess of Stock Basis (a – b)$50,000
Trump Tax Cut Deduction (20%)($10,000)
Taxable Income on S/H Distribution$40,000
2020 Long-Term Capital Gains Tax (15%)($6,000)
Total Taxes on Income($16,063)($22,164)

In this example, you would save $7,230 in payroll taxes by lowering your income, and you would save $6,101 in taxes from the beneficial corporate tax treatment. In this example, we assume the stock basis is $0 (put simply, the stock basis is what you paid for your shares in the company – if you paid $10k for the shares in your S-corp when you set it up, you could distribute $10k without paying any taxes on it as this is viewed as a return of your original investment; after your cumulative distributions exceed the stock basis, the distributions are no longer tax free and are taxed at the still lower long term capital gains which we used in the above example). 

Also note that there is a benefit from the changes in the tax code made during the Trump administration (called the 199A or Qualified Business Income deduction) which is set to expire in 2025. This lets S-corps, LLCs, and partnerships deduct 20% of their taxable income, which in our example results in a $10k deduction. The deduction applies as long as you make less than $167k of income as an individual or $321k of income as a couple. Notably, if you were at $200k of income as an individual and wouldn’t qualify, the S-Corp salary could get you into compliance. So if you paid yourself a $100k salary, and your business income was now only $100k, you’d qualify for the 20% deduction. 

Between the payroll tax savings of $7,230 and the income tax savings of $6,101, it would seem to make sense for this higher income earner to set up an S-corp. 

In order to become an S-corporation, qualifying corporations must submit to the IRS Form 2553 Election by a Small Business Corporation (found here) signed by all the shareholders. If you just set up the business, you must file the paperwork within 2 months and 15 days of organizing to receive the S-corp taxation treatment for that year. If your business is already established, you need to have the paperwork filed by March 15th to receive the S-corp taxation for that year. To qualify for S-corp status, the corporation must meet the following requirements:

  • Be a domestic U.S. corporation
  • Have only allowable shareholders (only individuals, certain trusts, and estates, and not partnerships, corporations or non-resident alien shareholders)
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

If a corporation wants to be treated as an s-corp but then fails to file the form or fails to qualify, they could face penalties from the IRS for filing taxes incorrectly. Payroll and accounting work is more complex for S-corps (for example, payroll taxes are due every two weeks or monthly, and forms are required for quarterly federal and state withholding taxes) however, there are firms that can help with this. 

Notably, it will change your tax forms slightly. The IRS views corporations as their own living, breathing, taxable entity. This is different from a single-member LLC or a sole-proprietorship which most freelancers use, as the IRS considers these “disregarded entities” (meaning these entities are just pass-throughs where the owner is responsible for the taxes). If you have an S-corp, you’ll have to file a Form 1120-S corporate tax return, and you’ll no longer use a Schedule C. You’ll calculate the income of the standalone business, and take the business expense deductions on Form 1120-S now. Then the income from this corporation will be distributed to the owner of the S-corp (you) on a Schedule K-1, which you’ll report on your Form 1040.